It's Time for Stock Buybacks

It has been a tough decade for investors, but things are looking up as companies look to add value to their stocks again, writes Paul Larson of Morningstar StockInvestor.

After getting bid up to nosebleed valuations in the late 1990s, stocks of many high-quality companies have seen their prices hold relatively flat or even fall.

But things are even worse if you move beyond prices alone. You see, when considering share repurchases, the perfor­mance is that much more anemic.

Take Wal-Mart (WMT), for just one example. Ten years ago, on September 6, 2001 (just before the horrific events of 9/11), Wal-Mart traded at $47.37, down from a high near $70 at the peak of the dot-com craziness.

Where does it trade at this writing? $51.68, not very far from where it did back then. Looking at price alone, Wal-Mart’s stock rose a scant 9% over that past decade.

But consider that Wal-Mart today has 21% fewer shares outstanding than it did ten years ago, and the price performance looks that much worse. Wal-Mart has gone from a market capitalization of $212 billion to just $178 billion today, a decline of 16%.

One can’t blame Wal-Mart’s management team for causing the poor price performance. While Wal-Mart has been far from perfect in its execution, taking a step back to see the bigger picture regarding what’s happened over the past decade:

revenue at the retail giant has roughly doubled

net income has nearly tripled

and earnings per share—aided by buybacks—have more than tripled.

Wal-Mart is far from alone; there are many companies where revenue and earnings have moved up and to the right consistently over the years, while their stocks have lain flat despite significant share repurchases. Blame a large overvaluation of the shares a decade ago—valua­tions that have come down significantly.

A decade ago, Wal-Mart traded at 33 times trailing earnings per share. Today it trades at a mere 11 times. I’d argue the pendulum swung too far toward premium valua­tions a decade ago, and now the pendulum has swung too far the other way.

I decided to take a look at just how many of our compa­nies have repurchased significant amounts of their own shares over the past decade. I was surprised at just how pervasive repurchases have been.

No fewer than 23 of the current holdings—roughly half our firms—reduced their diluted shares outstanding at least 5% in recent years. Moreover, 17 of these companies had repurchased at least 10%, eight had repurchased at least 20%, and three—ExxonMobil (XOM), Amgen (AMGN), and Dell (DELL)—had repurchased at least 25%.

Many of the companies that attain a wide moat rating are relatively mature, and tend to generate copious amounts of cash even after paying for their own internal growth. Management has three options regarding what it can do with this excess cash.

For one, it can acquire other companies. Since most acquisitions destroy value, this is the least attractive option for us as minority owners.

Second, they can pay the cash out. Dividends are always a positive contributor to shareholder returns, and usually the most attractive option.

But I also happen to think the third option, buybacks, can be positive.

Buybacks allow long-term owners to increase their ownership position without contributing additional capital. Moreover, the buybacks reduce the number of mouths to feed, often enabling greater dividend increases than would otherwise be considered.

As long as a company is buying back stock below our fair-value estimates, I generally applaud repurchases.

Valuations Keep Things Interesting
In today’s market, we’re at a point where there is a tug of war between positive and negative factors, and the tension on the rope is exceptionally high.

On one hand, the economy is anemic, the European sovereign debt situation remains unsolved, and we also have our own government debt and deficit issues. Pulling on the other end of the rope, the 2008-09 recession is not very far in the rearview mirror, and it’s not like there has been a lot of inventory or excess capacity built up in the economy.

More importantly for us as investors, valuations in the market remain very compelling. Following this decade-long streak of compression in valuation multiples—exacerbated by share repurchases—there are now a large number of relatively high-quality stocks trading at single-digit multiples of estimated forward earnings.